New York: The world’s biggest futures and options exchanges are failing to break Wall Street’s hammerlock on credit-default swaps, the world’s fastest-growing financial market.
Three weeks after Eurex AG, Europe’s biggest futures exchange, introduced the first contracts that allow investors to bet on a company’s ability to pay its debt, 231 million euros ($313 million) have changed hands. Banks including JPMorgan Chase & Co., Citigroup Inc. and Goldman Sachs Group Inc. trade about 15 billion euros of credit-default swaps each day, according to data compiled by Frankfurt-based Deutsche Bank AG.
The banks are refusing to trade the Eurex contracts, heading off competition in a market that doubled to $294 billion in the year ended in June, according to the Bank for International Settlements in Basel. The Chicago Mercantile Exchange, the biggest US futures exchange, and the Chicago Board Options Exchange, the biggest US options markets, expect a similar reception when they introduce credit derivatives this year.
Rs.The dealer community is not really supporting this,’ said Joe Levin, the CBOE’s vice president of research and product development in Chicago.
Credit-default swaps, conceived more than a decade ago by bankers in New York and London as a way to protect lenders against default, now are used by hedge funds and investors as a less expensive way of betting on the creditworthiness of companies than purchasing bonds.
The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should the company fail to keep to its debt agreements. A drop in the cost of the contracts indicates an improved perception of credit quality.
Keeping a Stranglehold
Banks and securities firms are keeping a stranglehold on the market, which has swelled to cover debt sold by more than 3,000 companies, governments and industries.
JPMorgan and Citigroup, both based in New York, and Bank of America Corp. in Charlotte, North Carolina, handled about 90% of the $9 trillion in credit derivatives trades in the fourth quarter among US commercial banks, the US Office of the Comptroller of the Currency in Washington said.
Bear Stearns Cos., also in New York, said in March that credit derivatives helped push net revenue in its fixed-income unit to a record $1.1 billion last quarter, 27% higher than a year earlier.
Rs.A Fizzle, Not Bang’
The International Swaps and Derivatives Association’s 22nd annual conference, which begins today in Boston, features as its keynote speakers European Central Bank President Jean-Claude Trichet and Bank of America Chief Executive Officer Kenneth Lewis. None of the exchanges are on the group’s list of exhibitors or speakers. The Merc, CBOE and Euronext.liffe, Europe’s second-largest derivatives exchange and a unit of New York-based NYSE Euronext, had booths at past conferences.
Societe Generale SA is the only one of the 20 biggest banks in credit-default swaps to trade the new contracts offered by Frankfurt-based Eurex. Bloomberg LP, the parent of Bloomberg News, provides the pricing model to calculate the settlement prices of the Eurex contracts.
Rs.Their introduction seems to have gone off with more of a fizzle than a bang,’’ said Simon Surtees, co-head of fixed income at Gartmore Investment Management in London, who helps manage about $3.6 billion of corporate bonds and credit-default swaps. Rs.The fact that I’m a bit in the dark about how these things operate suggests that they haven’t made any great concerted effort to contact investment institutions.’’
Exchanges, which have traded futures and options on bonds and interest rates for more than a decade, said four years ago that they planned to penetrate the credit derivatives markets.
The exchanges are Rs.pretty late to the game,’’ said Jeff Lenamon of Diversified Credit Investments in San Francisco. Rs.They should have done that six or seven years ago. Most people are pretty happy with how the credit derivatives market works.’
The Singapore Exchange Ltd., which runs that country’s securities and derivatives market, became the first bourse to announce plans for credit-default swap trading in December 2003. It still doesn’t list any of the contracts.
Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.
Eurex and the Chicago markets want to offer contracts on indexes created by banks that track credit-default swaps. Dealers have created four indexes in the US and three in Europe. In the US, they are known as CDX and in Europe they are called iTraxx.
Eurex will give investors the ability to bet on gains and losses in three iTraxx indexes, one for investment-grade companies, one for companies that straddle the line between investment-grade and high-risk, high-yield and one that includes the riskiest investment-grade companies. The contracts mature every five years, with new futures issued every six months.
Boycotting the Contracts
Banks are boycotting the contracts. JPMorgan’s London-based head of credit trading, Guy America, described the Eurex contracts as Rs.flawed’ and unlikely to succeed in drawing traders. New York-based ISDA, which represents 750 institutions, said last month it was investigating whether the contracts could Rs.adversely’ influence bond prices.
Rs.Not all the banks are being helpful,’ said Eurex spokesman Heiner Seidel in Frankfurt. Rs.Rs.It’s not obvious to us that our product will take business away from the banks. We can add liquidity to the whole market.’’
The Chicago Merc, which plans to start offering a futures contract modeled after the CDX indexes on 6 May, has yet to name market-makers. NYSE Euronext and the CBOE are also planning to enter the market.
Rs.Clearly, the CDX is the dominant index in the US,’’ said Robin Ross, a managing director at the Chicago Merc. Rs.That would be the logical benchmark.’ The exchange wouldn’t discuss its conversations with the index owners.
CDS IndexCo LLC, the group of 16 banks that own the CDX indexes, declined to comment on discussions with the exchanges, said spokesman Michael Mandelbaum in Los Angeles.
JPMorgan, Morgan Stanley, Goldman Sachs and the 13 other dealers that own the benchmark credit-default swap indexes haven’t granted licenses to the US exchanges for their contracts. None of the banks that own the CDX indexes has agreed to buy and sell the contracts the CBOE may start trading next month, the CBOE’s Levin said. Morgan Stanley and Goldman Sachs are based in New York.
Rs.We’re offering a standardized product that’s going to be transparent,’’ Levin said. Rs.They do it over-the-counter in an opaque, non-transparent way.’
Falling Profit Margins
The banks have seen profit margins fall when they make prices easier to find and markets more transparent. Earnings from trading corporate bonds tumbled after the National Association of Securities Dealers in 2002 required traders to post details of bond transactions on a centralized computer system known as the Trade Reporting and Compliance Engine.
The difference between bids to buy and offers to sell corporate bonds narrowed by about half, or 8 basis points, in the first year after the July 2002 introduction of Trace, representing $1 billion in lost commissions, according to Kumar Venkataraman, a professor at Southern Methodist University in Dallas, who teaches portfolio management at the Edwin L. Cox School of Business. A basis point is 0.01 percentage point.
Rs.I don’t believe that the liquidity will be better on the exchanges,’’ said Jeffrey Kushner, a managing director at New York-based BlueMountain Capital Management LP, which manages about $3.1 billion. Rs.The hedge fund community, especially those that trade credit derivatives as a core product, isn’t going to use this product, nor the banks.’’
Eurex executives say the contracts are too new to be written off. They wrote to investors this week to respond to concerns.
Rs.The first days of trading are not an indication of the success or failure of the product,’’ said Seidel of Eurex. Rs.We believe in the potential of the product, especially in light of the interest we’ve seen from the buy-side.’
A survey of investors by New York-based Merrill Lynch & Co. suggested trading in the Eurex credit futures may pick up. More than 80% of those polled said they plan to trade the contracts. Almost a third wanted to trade them because they couldn’t trade credit-default swaps in the private market.
Rs.We’d be willing to look at any of these products that make sense from a liquidity and pricing perspective, but we think it will be some time before that develops in any of these products,’’ said J.J. McKoan, who oversees about $60 billion in assets as director of global credit at AllianceBernstein LP in New York.
The biggest problem for the US exchanges is how the contracts work, said David Boberski, head of US interest-rate strategy in New York at Bear Stearns and the author of Rs.Valuing Fixed Income Futures.’’ (McGraw-Hill, 304 pages, $75)
The values of credit-default swaps created by dealers are partly derived from an estimate of what the buyer would recover in the event of a bankruptcy. The recovery rates vary from company to company, and industry to industry.
The Merc says its futures contract will have the same expected recovery rate regardless of company or industry. The CBOE’s options will pay a flat rate, not a recovery rate.
Rs.Whenever you create a futures product that has economics that differ from the over-the-counter market, you’re asking traders to make a leap of faith, in this case a $30 trillion leap of faith,’’ Boberski said in an interview. Rs.They’re asking the over-the-counter market to remake itself in the image of the exchange, and it will never happen.’’
Even if the first products fail, the exchanges can’t be counted out, Boberski said.
Rs.The potential for this market is far greater than any of those dealers perhaps even recognize themselves because this market evolved in a time of very low volatility and relatively robust economic growth with few bankruptcies,’’ he said. Rs.Rs.What happens when there are a significant number of bankruptcies? Trading will spike. It makes a lot of sense to have the exchanges as a backstop for those clearing and settlement issues.’’
The Chicago Merc’s Ross has a 1982 magazine article pinned to the bulletin board in her office describing the Rs.disappointing debut’ of the Eurodollar futures, now the world’s most actively traded futures contract and a popular way to bet on US interest rates.
Ross refers to the article from Institutional Investor whenever skeptics say the Merc, along with the CBOE and Eurex, have little to show for a three-year effort.
Rs.C’mon,’’ she said. Rs.It takes time.’